Aflac: Still Undervalued, Still with Risk

-Revenue Growth Rate: 8.5% Dividend Stock Report
-EPS Growth Rate: 11.1%
-Book Value Growth Rate: 11.6%
-Dividend Growth Rate: 17.2%
-Current Dividend Yield: 2.23%
-Financial Strength: AA-, Aa3

Aflac’s core performance has been remarkable over the last decade, and they have improved their financial condition compared to last year. Concerns over a potential Japanese default are keeping the stock valuation low.


AFLAC Incorporated (NYSE: AFL) is a large international supplemental insurer. They provide cash that can cover several types of expenses to those receiving payouts due to illness or deaths. This is supplementary to primary medical insurance which helps cover medical expenses but leaves other expenses without a solution. This Fortune 500 company was founded in 1955, and has a large presence in Japan and the US. AFLAC stands for the American Family Life Assurance Company.

The company made a big move in Japan in the 1970s by selling insurance for cancers when people were becoming particularly mindful of cancer. Decades later, approximately three-quarters of Aflac’s diverse premiums now come from Japan.

Aflac primarily targets places of employment for its insurance products, rather than individuals outside of work. The company offers plans to employers that allow them to provide Aflac insurance as part of their benefits package to employees without paying any cost themselves.

The premise behind an insurance company is that they spread risk out over a wide number of people and businesses. They collect premiums (payments) from clients and in return those clients are covered in case of a serious loss. From an insurance business standpoint, it’s ideal to collect more in premiums than you pay out for losses. This is not the primary form of earnings, though. An insurance business, after collecting all of the premiums, holds a great deal of assets that, over time, are paid out for client losses. An insurance company constantly receives premiums and pays out for losses, so as long as they are prudent with their business, they get to constantly keep this large sum of stored-up assets. As any investor reading this knows, a great sum of money can be used to generate income from investments, and that’s how an insurance company really makes money. Aflac invests its stored up collection of assets primarily in fixed income securities to receive upwards of $3.4 billion in annual investment income.


Price to Earnings: 8.7
Price to Book: 2.1


Aflac Revenue
(Chart Source:

Aflac has had particularly strong core business performance over the last decade. Revenues from both premium income and investment income have increased every year for at least the last ten consecutive years, although this is so far not the case for the trailing twelve month period and it appears that the streak will be broken. The annualized revenue growth rate over the last seven years was 8.5%.

Earnings and Dividends

Aflac Dividends
(Chart Source:

Aflac has had somewhat erratic EPS numbers, but the average growth over this seven year period was 11.1% per year. EPS spiked to $7.20 over current the trailing twelve month period, which the chart doesn’t show. The company’s operating earnings per share, which excludes yen currency effects, impairments, and certain other items, has increased every year for over two consecutive decades.

As for the dividends, Aflac has increased the dividend for thirty consecutive years. The payout ratio is rather low, at under 20%. Despite the low payout ratio, the dividend yield at 2.23% is at least higher than the average S&P 500 yield, because the stock valuation is so low. The yield was closer to 3% last year before the stock price increased substantially. The payout ratio is actually lower than it was 5 years ago because earnings have strengthened recently and the dividend was only increased at a moderate rate, so I’d expect the dividend increases over the next few years to be rather generous.

Approximate Historical Dividend Yield at Beginning of Each Year:

Year Yield
Current 2.23%
2013 2.7%
2012 3.0%
2011 2.1%
2010 2.3%
2009 2.1%
2008 1.3%
2007 1.4%
2006 0.9%
2005 1.0%

As can be seen, the dividend increased quickly earlier in the decade but then began increasing more slowly during the worldwide financial crisis. This leaves extra room for dividend growth over the next few years, assuming their Japanese market remains reasonably strong.

Balance Sheet

The balance sheet dynamics have changed during the previous few years. The company’s large investment portfolio had significant exposure to some of the most financially troubled European countries, and this resulted in billion-dollar capital losses in the peak years of the problem. Aflac has managed that situation well, but now the issue that’s keeping the stock valuation low is their exposure to Japanese default risk.

Realized Investment Gains (Losses) By Year, in Millions:

Year Gain / (Loss)
Trailing 12 Months $471
2012 ($349)
2011 ($1,552)
2010 ($422)
2009 ($1,212)
2008 ($1,007)
2007 $28
2006 $79
2005 $262

Gains and Losses from the portfolio were a fairly minor portion of the business until 2008 when the financial crisis began showing itself. With over $1 billion in impairments in certain years, this kept the stock price and the stock valuation low.

Investment Thesis

Aflac has a notable business model. Rather than targeting individuals, Aflac insurance agents target businesses. Aflac works with employers to give employees the option to purchase Aflac Insurance via payroll deductions, similar to their other benefits. This “cluster-selling” technique keeps costs comparatively low, and gives the company a major competitive price advantage. It creates a win-win situation with employers it does business with.

In addition to having a solid distribution network for its insurance products, Aflac has a strong brand name that is well known in Japan and US, with the duck mascot. The brand is stronger than most other insurers, especially in Japan.

Plus, its insurance is rather resistant to health care reform or other insurance regulation (although not untouched). The company provides supplemental insurance; cash to people when they need it most.

The company has been recognized as one of the “World’s Most Ethical Companies” by Ethisphere Magazine, and also one of the best places to work. It has won similar awards from a variety of sources.

Aflac’s US exposure is significantly smaller than its Japanese exposure despite being a US-based company. Their customer retention rates are not as high in the US as they are in Japan, but the other side to this is that there is more growth and improvement opportunity.


Aflac, despite superior performance over the last decade, has faced some of the harshest macroeconomic problems there are. During the financial crisis, they had several billion dollars worth of exposure to bonds from the European countries that were being bailed out, which resulted in investment losses. Over the last year, this risk has shifted away from Europe and to Japan.

Japan is one of the world’s largest economies, and has the highest ratio of public debt to GDP out of any country in the world. The ratio is well over 200%, which is more than twice that of the United States. This has historically not been a problem for Japan for the last couple of decades because the strong economy kept interest rates low. As long as the interest rates were low, the debt was easy to maintain. (In comparison, those European countries with lower debt-to-GDP ratios began entering default during the financial crisis because investors lost confidence in the economies of those countries and interest rates spiked to unworkable levels.) The interest rates in Japan are still very low, so there’s still not a current issue. But, it has become increasingly clear to investors that Japan is heading to a problem. The debt is extremely high, and the economy is faltering from the declining and aging population. A declining population makes economic growth extremely difficult to obtain and can affect housing prices with extra supply (essentially the same problem as the United States faced but without the benefit of population growth which can eventually fix problems of over supply), while the aging population puts more stress on government programs and on younger taxpayers.

Aflac does most of its business in Japan and holds a considerable portion of its assets in Japanese debt. The extreme case of a Japanese default would be extremely damaging to Aflac. Quantitatively, about 40% of Aflac’s $100 billion+ investment portfolio is held in Japanese Government Bonds. That’s the portion that’s at risk if there were to ever be a government default, and additional risk would likely come from a reduction of premiums even in moderate scenarios without a default but with a debt/economic crisis.

Conclusion and Valuation

Wow, what a run. I published a report on Aflac 14 months ago suggesting that the price of under $46 at the time was appealing, even using an aggressive 12% discount rate, and the stock is now up to nearly $63. With dividends added, that’s a nearly 40% rate of return on paper in 14 months.

Dividend investors, however, are interested in long-term growth. The forward-looking question is whether the stock price remains attractively priced, or whether this run-up has taken the attractiveness out of the stock. To be sure, the current low P/E ratio of under 9 is very low, and lower than the historical average of the company. This makes their share buybacks particularly effective at boosting EPS. So, the share price increase has not been from an increase in valuation, but rather from an increase in reported earnings and a flat valuation on those increasing earnings, which translated into a substantially increased stock price.

To estimate Aflac’s fair value, we can do a two stage Dividend Discount Model. If the company grows EPS by an average of 9% going forward, which is below historical growth, then the dividend can increase at a rate of 12% per year over the next ten years to increase the payout ratio to only 30% at the tenth year. After that, the dividend could be assumed to grow at the same rate as EPS. Applying an aggressive 12% discount rate (the target rate of return), the calculated fair price is nearly $65/share, compared to the current actual price of under $63/share. In reality, EPS growth is not going to be smooth and it’s impossible to say what level management will want the payout ratio to be in ten years even assuming slowing of EPS growth. The point is, even assuming a slowing of growth, the company can be calculated to be at an attractive value for a 12% rate of return.

In a more conservative scenario, if the company grows the dividend by only 10% per year over the next 10 years followed by 7% thereafter, which is considerably below what has been typical for the company, and a less aggressive 10% discount rate (target rate of return) is used, then the calculated fair price is just under $64, which is comparable to the current price of about $63.

So, in a variety of scenarios, if Aflac continues operating normally, the stock is noticeably undervalued. The combination of dividend yield and dividend growth, with 30 years of consecutive annual dividend growth, is one of the better combinations you’ll find on the market.

Clearly, this undervalued status is due to very real concerns about the Japanese economy. If Japan has a default or otherwise has a severe economic contraction, all bets are off. EPS growth, and consequently dividend growth, will run into walls if Japan defaults or enters a more tangible economic crisis, and the portfolio value will be at risk. Aflac is considered a short opportunity for those that are bearish on the Japanese default risk, with some predictions of the stock price being cut in half over the next year.

For this reason, I continue to view Aflac as a dividend investment that has an above average risk profile and above average potential returns if those risks don’t unfold. Most investor portfolios do not have substantial direct exposure to Japan, so holding Aflac stock may be a way to diversify into a concerned region if you’re not as bearish on the economy of Japan as some are. Aflac at this time does not appear to be a good candidate for a core holding if you’re concerned about the Japanese economic risk, but should provide above average returns if the more bullish or optimistic views of Japan end up being correct.

Full Disclosure: As of this writing, I have no position in AFL.
You can see my stock portfolio here.

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Chevron: Growth From Australian LNG

-Seven Year Average Revenue Growth Rate: <3% Dividend Stock Report
-Seven Year Average EPS Growth Rate: 10.7%
-Seven Year Average Dividend Growth Rate: 10.5%
-Current Dividend Yield: 3.26%
-Balance Sheet Strength: Perfect

Chevron appears to represent a decent buying opportunity at this time in the mid-$120’s.


Founded in 1879, Chevron (NYSE: CVX) is currently one of the largest oil and gas companies in the world. The company is involved in almost every type of energy business available.

Exploration and Production
In 2012, Chevron produced an average of 2.61 million barrels of oil per day, and at the end of the year their proved oil-equivalent reserves were 11.35 billion barrels. The company has exploration and production operations all over the world, and tends to particularly specialize in deep sea drilling.

Gas and Midstream
Chevron has a strong vertically integrated natural gas business. They’re involved in liquefaction, pipelines, marine transport, marketing/trading, and power generation. The company has 160 billion cubic feet of natural gas resources.

Downstream and Chemicals
In 2012, Chevron processed 1.7 million barrels of oil per day on average. This results in fuels, lubricants, and petrochemicals. There are over 16,000 stations selling Chevron products.

The company operates technology centers in the United States, United Kingdom, and Australia where they develop technology for use in the other business areas.

Renewable Energy and Energy Efficiency
Chevron is one of the largest global producers of geothermal energy, and is also involved in the solar energy industry and the non-food biofuel industry. Chevron Energy Solutions installs large solar arrays for clients.

Valuation Metrics

Price to Earnings: 10
Price to Free Cash Flow: Highly Variable
Price to Book: 1.7


Chevron Revenue
(Chart Source:

Chevron has somewhat erratic revenue growth, with an average of under 3% per year. The growth comes from production quantity as well as the current pricing of their commodities and end-products.

Earnings and Dividends

Chevron Dividends
(Chart Source:

Chevron has enjoyed 10.7% average EPS growth over the last seven years, although these numbers were also made erratic during the financial crisis. This is fairly strong EPS growth, considering that the company also pays a higher than average dividend yield to shareholders.

The dividend growth rate over the same period was about 10.5% per year, and so the dividend payout ratio has remained flat at around 25%. The earnings of oil companies tend to be cyclical, so they keep payout ratios on the lower end so that the dividend can be grown even during the barely profitable periods. The current dividend yield is a healthy 3.26%, and the company recently achieved 25 years of consecutive annual dividend growth.

Approximate Historical Dividend Yield at Beginning of Each Year:

Year Yield
Current 3.26%
2013 3.3%
2012 3.0%
2011 3.2%
2010 3.6%
2009 3.4%
2008 2.4%
2007 2.9%
2006 3.1%


How Does Chevron Spend Its Cash?

Chevron brought in over $34 billion in free cash flow cumulatively during the fiscal years of 2010, 2011, and 2012. Over the same time period, the company spent about $3 billion on acquisitions, nearly $19 billion on dividends, and about $4 billion on share repurchases.

Balance Sheet

Chevron’s balance sheet is about as strong as they come. Total debt/equity is only 14%, and the amount of goodwill on the balance sheet is negligible compared to equity. The debt/income ratio is less than 1x, and the interest coverage ratio is extremely high. Not counting other long term liabilities, there is more cash sitting on the balance sheet than there is total short term and long term debt.

Balance Sheet Expansion

Year Total Assets Total Liabilities Shareholder Equity
Current $244.0 billion $101.2 billion $142.8 billion
2012 $233.0 billion $96.5 billion $136.5 billion
2011 $209.5 billion $88.1 billion $121.4 billion
2010 $184.8 billion $79.7 billion $105.1 billion
2009 $164.6 billion $72.7 billion $91.9 billion
2008 $161.1 billion $74.5 billion $86.6 billion
2007 $148.8 billion $71.7 billion $77.1 billion
2006 $132.6 billion $63.7 billion $68.9 billion

Shareholder Equity has grown by an average of 11% annually over this seven-year period.

Investment Thesis

Chevron is constantly developing new upstream resources, but the key growth over the next several years will be from Australia. The company’s LNG production is going to more than double in the next four years, primarily due to the Gorgon (operational in 2015) and Wheatstone (operational in 2016) projects in Australia. Gorgon had budget overruns but these challenges have been worked through, and the project is now two-thirds complete. The other two main sources of growth will be from deepwater drilling and from shale production.


Large oil companies have among the largest and broadest set of risks for any investment.

There is an ever-present risk of an environmental catastrophe, which can lead to up to ten-figure lawsuits. Chevron is still dealing with the nearly $20 billion litigation risk related to operations in Ecuador, which were part of the Texaco acquisition in the 90’s. Recent court decisions have generally favored Chevron on these matters.

More regularly, the company has to deal with more commonplace instances of litigation, changing oil and other commodity prices, and managing its oil and gas reserves in a competitive environment driven by scarcity. The company has reported 112% reserve replacement rates on average over the last five years, meaning that reserves are being maintained and grown at the current time.

Conclusion and Valuation

Chevron consistently adapts to changing energy needs, with a currently strong presence in deepwater drilling, moves towards shale production, and huge investments in LNG, along with smaller operations like Chevron’s Energy Solutions (solar) business. The company has a 25 year history of paying growing dividends, and currently offers a reasonable dividend yield of over 3% with a low and safe payout ratio.

Based on a two-stage Dividend Discount Model, assuming a 10% discount rate, if the company grows its dividend by 9% per year for the next decade and 7% per year thereafter, then the calculated fair price for the stock today is over $147. The current price of under $123 gives a more than 15% margin of safety for these estimated figures, leading to what appears to be a reasonable buying opportunity in a diversified and financially stable dividend-paying company.

Full Disclosure: As of this writing, I am long CVX.
You can see my dividend portfolio here.

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Medtronic Dividend Stock Analysis 2013

-Seven Year Revenue Growth Rate: 5.6% Dividend Stock Report
-Seven Year EPS Growth Rate: 7%
-Seven Year Dividend Growth Rate: 15%
-Current Dividend Yield: 2.08%
-Balance Sheet Strength: Very Strong

Medtronic looks solid in the mid-$50’s, but not with a margin of safety. Looking for dips or writing puts would be a more conservative approach.


Founded in 1949, Medtronic, Inc. (NYSE: MDT) is a medical technology company focusing on alleviating pain, restoring health, and extending life for people all over the world. With over 46,000 employees and a market capitalization of over $50 billion, Medtronic is the world’s largest independent medical device company.

Approximately 45% percent of company revenue comes from outside of the United States. The company markets its products in over 120 countries.

The company is divided into two primary groups.

Cardiac and Vascular Group

Medtronic’s core area of expertise has long been the heart and related systems, and slightly more than half of total company sales come from this group. The group contains four segments:

Cardiac Rhythm Disease Management
This segment accounts for 30% of total company sales. Products in this segment include pacemakers, implantable defibrillators, leads and delivery systems, ablation products, electrophysiology catheters, and other products.

Coronary, Structural Heart, and Endovascular
These other three heart segments account for 11%, 7%, and 5% of total company sales.

Restorative Therapies Group

Medtronic has been growing their products for ailments unrelated to the heart since the 1990’s, and now they collectively represent nearly half of company sales.

This segment accounts for 19% of total company sales. Products in this segment include thoracolumbar, cervical, neuromonitoring, surgical access, and more.

This segment accounts for 11% of total company sales. Products include implantable systems for treatment of chronic pain, movement disorders, bladder problems, and other conditions.

This segment accounts for 9% of total sales. Products include insulin pumps and disposable products.

Surgical Technologies
This segment accounts for 9% of total sales. Products of this segment are used to treat ear, nose, and throat conditions.


Price to Earnings: 15.4
Price to Free Cash Flow: 13.4
Price to Book: 2.9


Medtronic Revenue
(Chart Source:

Revenue growth was a solid average of 5.6% per year over this period. It’s consistent as well- looking back over a decade there have not been any years where revenue fell compared to the previous year.

Earnings and Dividends

Medtronic Dividends
(Chart Source:

Growth of EPS per share was fairly mediocre, at 7% per year on average. The growth was rather erratic as shown on the chart, but this was due to reasons other than core profitability from sales. Multiple variables of litigation costs, acquisition-related items, and restructuring charges, were involved each year. For example, the low figure of 2009 was due to a combination of substantial litigation and acquisition-related items.

Those costs are part of doing business, but factoring them out to get a different look at profitability shows that, if those types of costs are factored out, EPS grew each year over this period compared to the previous year.

The dividend growth rate over the same period averaged 15% per year, because the company wisely decided to increase its payout ratio from under 20% to currently just over 30%. The current yield is still fairly low at 2.08%, and the company has three and a half decades of consecutive annual dividend growth without a miss.

Approximate historical dividend yield at beginning of each year:

Year Yield
Current 2.1%
2013 2.4%
2012 2.5%
2011 2.4%
2010 1.8%
2009 2.3%
2008 1.0%
2007 0.8%
2006 0.7%


How Does Medtronic Spend Its Cash?
Over the fiscal years of 2011, 2012, and 2013, Medtronic brought in $11.6 billion in cumulative free cash flow. Over the same period, $3 billion was spent on dividends, $3.8 billion was spent on share repurchases, and $2.3 billion was spent on net acquisitions.

Balance Sheet

The total debt/equity ratio of the company is about 60%. Of the nearly $19 billion in existing shareholder equity, over $10 billion of that is goodwill.

Total debt/income is a bit over 3x, and the interest coverage ratio is nearly 30, which is extremely healthy.

Investment Thesis

A considerable portion of the total Medtronic offer of shareholder returns comes from dividends and buybacks. The second major portion comes from expanding the business with small and medium acquisitions and research and development of more advanced products in developed markets. The third key portion is to expand their platform to less developed areas that may be considered roughly developed, but aren’t nearly at the same level of health care spending as some of the most developed areas.

Dividends and Buybacks
The shareholder yield of Medtronic tends to be about 4-5% per year, which represents a fairly reliable portion of returns over the long term; dividends are immediate and buybacks increase EPS. Add onto that perhaps 2% top line pricing growth each year to keep up with inflation which boosts revenue and income, and the result is that 6-7% of total returns come before actual company growth. Growth adds onto that foundation of returns to get us up to where we want to be at around 10% annual returns or better, so before core growth is even factored in we’re already two-thirds of the way there (a reminder of the virtue of a good dividend stock, even if Medtronic’s yield is at least 1% lower than I’d like).

Research, Development, and Acquisitions
Medtronic spends about $1.5 billion, or roughly 3% of market cap, on R&D each year. This includes new and improved medical devices, such as new products to treat conditions, updates on existing products for increased effectiveness or increased longevity, or updates on existing products to make them resistant to the effects of MRI scans. Major pipeline projects for fiscal year 2014 include the RestoreSensor SureScan MRI spinal cord system, the MiniMed 530g/640g diabetes systems, and the Endurant II AAA stent graft.

Acquisitions by their nature tend to be more erratic, but it’s not uncommon for Medtronic to spend 2% or more of its market cap on acquisitions in a given year. The Aquamantys system, acquired in 2011, uses a combination of RF technology and a saline to reduce blood loss during surgery. The PEAK PlasmaBlade is a scalpel that uses pulsed plasma technology. A typical scalpel cuts but causes significant blood loss, so an alternative is to do electrosurgery which uses electrical current to produce heat and cut tissue, which reduces blood loss but can cause thermal damage. Pulsed plasma technology is reported to do less thermal damage than electrosurgery while maintaining satisfactory blood loss control.

Market Expansion
Medtronic continues to invest and expand into markets with the idea that they should pay well in the future. In particular, Medtronic makes acquisitions and expands treatment options into China each year, so that they can establish a strong platform in the country as it grows per-capita GDP and health care costs.


Like all large health care companies, Medtronic faces considerable litigation and regulatory risk. As mentioned in the EPS section, EPS can be materially affected by litigation costs alone. There’s also regulatory risk, which can delay or disrupt large product introductions.

A major industry risk is that health care costs, especially in the United States, are considered by many to be out of control. The United States is the third most populated country in the world and has by far the highest per capita health care costs, but this is breaking both the federal budget and the budgets of middle class workers and their employers attempting to provide health care benefits to them. Any reductions in health care spending to try to reign in health care costs may impact medical devices, with Medtronic being the largest industry player.

Conclusion and Valuation

With consistent revenue growth, a very strong balance sheet, a long history of dividend growth, and a mediocre current dividend yield, Medtronic can be a decent health care selection for a portfolio.

Based on the Gordon Growth Model using a 10% discount rate (target rate of return), if Medtronic grows its dividend by an average of 8% per year for the foreseeable future, then the calculated fair value is a bit over $57. The current price is about $54. However, the most recent dividend increase was a bit under 8%, and if the average projected dividend growth rate drops to even 7.5%, then we’re looking at a fair value of more like $45. The model is sensitive for lower yield stocks, and there isn’t really a margin of safety here.

Another path is to hold off for dips, or write put options on the stock at a strike price about where the price is now. The February 2014 contracts at a strike price of $52.50 aren’t bad (results in a cost basis of about $50 if exercised), and for a longer term idea, the January 2015 contracts at a strike price of $55 potentially offer a decent annualized rate of return with a current cost basis of a bit below $49.

Full Disclosure: As of this writing, I am long MDT.
You can see my dividend portfolio here.

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